In some industries it is common practice for customers to have the right to return a product to the seller for a credit or refund. However, for companies that experience a high ratio of returned merchandise to sales, the recognition of the original sale as revenue is questionable. In fact, certain industries have found it necessary to defer revenue recognition until the return privilege has substantially expired. Sometimes the return privilege expires soon after the sale, as in the newspaper and perishable food industries. In other cases, the return privilege may last over an extended period of time, as in magazine and Accounting book publishing and equipment manufacturing. The rate of return normally is directly related to the length of the return privilege. An accounting issue arises when the recognition of revenue occurs in one period while substantial returns occur in later periods.
FAS 48, Revenue Recognition when Right of Return Exists, reduced the diversity in the accounting for revenue recognition when such rights exist. FAS 48 provides criteria for recognizing revenue on a sale in which a product may be returned (as a matter of contract or a matter of industry practice), either by the ultimate consumer or by a party who resells the product to others. Paragraph 6 states the following:
If an enterprise sells its product but gives the buyer the right to return the product, revenue from the sales transaction [is] recognized at time of sale only if all of the following conditions are met:
- The seller’s price to the buyer is substantially fixed or determinable at the date of sale.
- The buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on resale of the product.
- The buyer’s obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product.
- The buyer acquiring the product for resale has economic substance apart from that provided by the seller.
- The seller does not have significant obligations for future performance to directly bring about the resale of the product by the buyer.
If all of the above conditions are met, the seller recognizes revenue from the sales transaction at the time of the sale and any costs or losses expected in connection with returns are accrued in accordance with FAS 5, Accounting for Contingencies. FAS 5 states that estimated losses from contingencies are accrued and charged to income when it is probable that an asset has been impaired or a liability incurred, and the amount of loss can be reasonably estimated.
The Interplay Between FAS 48 and FAS 5 Needs Further Explanation
Although FAS 48 requires under condition f. that the amount of returns be reasonably estimated, it does not reference the standard to the FAS 5 loss accrual criteria. Accordingly, a strict interpretation of both FAS 48 and FAS 5 would indicate that only when the conditions for loss accrual under FAS 5 are met (i.e., the loss is both probable and reasonably estimable) would condition f. under FAS 48 also be met, and both sales and estimated returns can be recognized. However, a more literal interpretation of FAS 48 indicates that, by not cross-referencing FAS 5, the FASB intended that the sole criterion for return accrual under FAS 48 be the “reasonably estimated” condition f. Then, whether losses are probable or reasonably possible, they would be accrued under FAS 48, and the sales would also be recognized. If the likelihood of losses is remote, no disclosure is required under FAS 5, and condition f. under FAS 48 would be achieved and revenue would be recognized with no need to record an allowance for estimated returns. Under this theory, only if returns cannot be reasonably estimated would recognition of revenue be precluded under FAS 48, regardless of whether losses are probable or reasonably possible.
Example Of Sale With Right Of Return
Assume that Lie Dharma, Inc. began the sale of its new Accounting book on computer programming in 2007 with the following results: On December 1, 2007, 2,000 Accounting Books with a sales price of $45 each and total manufacturing costs of $30 each are delivered to school bookstores on account. The bookstores have the right to return the Accounting books within four months of delivery date.
Payment is made when the books are sold. Payments and returns for the initial deliveries are as follows:
Lie Dharma, Inc. has had similar agreements with the bookstores in the past and has experienced a 15% return rate on similar sales.
If all the above six of the requirements were met, the following journal entries would be appropriate:
[Debit]. Accounts receivable = $90,000
[Credit]. Sales (2,000 units × $45 per unit) = $90,000
(To record sale of 2,000 Accounting books)
- [Debit]. Cash (600 units × $45 per unit) = $27,000
[Credit]. Accounts receivable = $27,000
(To record cash receipts for the month)
- [Debit]. Cost of sales = $60,000
[Credit]. Inventory (2,000 units × $30 per unit) = $60,000
(To record cost of goods sold for the month)
- [Debit]. Sales (15% × 2,000 units × $45 per unit) = $13,500
[Credit]. Cost of sales (15% × 2,000 units × $30 per unit) = $9,000
[Credit]. Deferred gross profit on estimated returns (15% × 2,000 units × $15 per unit)= $4,500
(To record estimate of returns)
[Debit]. Cash = $54,000
[Credit]. Accounts receivable = $54,000
(To record cash receipts)
[Debit]. Inventory (160 units × $30 per unit) = $4,800
[Debit]. Deferred gross profit on estimated returns = $2,400
[Credit]. Accounts receivable (160 units × $45 per unit) = 7,200
(To record actual returns)
[Debit]. Cost of sales (140 units × $30 per unit) = $4,200
[Debit]. Deferred gross profit on estimated returns = $2,100
[Credit]. Sales (140 units × $45 per unit) = $6,300
(To record expiration of return privileges and adjust estimate to actual)
- The revenue and cost of goods sold recognized in 2007 are based on the number of units expected to be returned, 300 (15% × 2,000 units).
- The net revenue recognized is $76,500 (85% × 2,000 units × $45 per unit); and
- The cost of goods sold recognized is $51,000 (85% × 2,000 units × $30 per unit).
- The amount of future returns can be reasonably estimated. For purposes of this statement “returns” do not include exchanges by ultimate customers of one item for another of the same kind, quality, and price.
- The deferred gross profit balance is carried forward until either the Accounting books are returned or the return privilege expires.
If all of the six conditions are not met, revenue and cost of sales from the sales transactions must be deferred until either the return privilege has substantially expired or the point when all the conditions are subsequently met is reached, whichever comes first.
If the facts in the Lie Dharma case were altered so that the bookstores were not required to pay Lie Dharma until the later of the date the books were actually sold or the expiration date of the return privilege, condition would not be met until the store remitted payment. The return privilege is, of course, assumed to be lost by the store when the books are sold to final customers. The following entries would be required:
[Debit]. Inventory on consignment = $60,000
[Credit]. Inventory = $60,000
(To record shipment of 2,000 units to retail bookstores on consignment; 2,000 units × $30 = $60,000)
- [Debit]. Cash (600 units × $45 per unit) = $27,000
[Credit]. Sales = $27,000
(To record cash receipts for December)
- [Debit]. Cost of sales (600 units × $30 per unit) = $18,000
[Credit]. Inventory on consignment = $18,000
(To record cost of goods sold for December)
[Debit]. Cash = $54,000
[Credit]. Sales (1,200a units × $45 per unit) = $54,000
(To record cash receipts)
[Debit]. Cost of sales (1,200 units × $30 per unit) = $36,000
[Credit]. Inventory on consignment = $36,000
(To record cost of goods sold on cash receipts)
- [Debit]. Inventory (160 units × $30 per unit) = $4,800
[Credit]. Inventory on consignment = $4,800
(To record product returns)
- [Debit]. Accounts receivable (40 units × $45 per unit) = $1,800
[Credit]. Sales = $1,800
(To record expiration of return privilege on remaining units)
- [Debit]. Cost of sales (40 units × $30 per unit) = $1,200
[Credit]. Inventory on consignment = $1,200
(To record cost of goods sold on products for which return privilege expired 1,800 units paid for – 600 units paid for in December 2,000 units sold – 160 units returned – 1,800 units paid for).
Disclosure Of The Right Of Return
If there is considerable uncertainty regarding the amount of potential sales returns, such as may be caused by a new product, potential product obsolescence, or heightened competition, then a company may be forced to not recognize any revenue at all until the right of product return has passed.
Since this can cause a substantial reduction in recognized revenue, a footnote describing the reason for the recognition delay would be in order. The information in the following footnotes illustrates a sufficient level of disclosure:
The company is in the beta testing phase of its new crop planting system, and so has granted an unconditional right of return to the first 10 customers who have agreed to purchase the product. The right of return privilege extends for six months from the shipment date. Since there is no return history for this new product, the company has recorded the total amount of all 10 sales in an Unearned Sales liability account, and will not recognize the revenue until the right of return period has expired. The total amount in this account is $328,000. Of this amount, $275,000 will be recognizable in March 2004, and the remaining $53,000 in May 2004, assuming that no products are returned in the interim.
The company’s light-saber product is entirely new and is being introduced into a new market, so management feels that it cannot estimate potential levels of product returns. Consequently, the company has not recognized any revenues related to recent shipments of the product until the three-month right-of-return period has passed. The company plans to reevaluate this policy after a sufficient amount of time has passed for it to make a better estimate of potential sales returns. The initial amount of light-saber revenues that would otherwise have been recognized in the first month of shipments was $1,750,000.
Financial Accounting Standards Board (FASB) Statement of Financial
Accounting Standards No. 5 (FAS 5), Accounting for Contingencies:
Paragraph 8, “Accrual of Loss Contingencies”
FASB Statement of Financial Accounting Standards No. 48 (FAS 48), Revenue Recognition when Right of Return Exists: